3. Risk taxonomy Flashcards
Risk concepts
Exposure
Volatility
Probability
Severity
Time horizon
Correlation
Capital
Exposure
Maximum loss that can be suffered from event
Volatility
Broadly measures variability within range of possible outcomes
Probability
Likelihood of an event
Severity
Loss likely to be expected from an event
Time horizon
Length of time exposed to risk OR time required to recover from / reverse effects of event
Correlation
Degree to which different risks behave similarly in response to common events
Capital
Risk- money set aside to cover unexpected losses
Working- money ser aside to support business strategy
What is risk taxonomy?
Full list, description and categorisating of risks faced by organisation
What are the 5 high level risk categories?
Market
Credit
Liquidity
Operational
Underwriting/insurance
Give a more detailed risk list
Define market risk
- Risks arising from changes in investment market values or other correlated features e.g. interest rates and inflation
- Incl. consequences of changes in asset values on liability values and asset liability matching
- May refer to risk of changes in the market conditions e.g. lower sales / profit margins
What are the components of market risk
Trading risk
A/L mimatching
Liquidity risk
Repatriation risk
Economic risk definition
Risk arising from impact of macroeconomic factors on an org and/or customers
Examples of economic risk
o Aggegrate supply and demand
o Own and foreign govt policies
o (Un)employment levels
o Inflation, interest and FX rates
o Accommocation costs incl house prices
Interest rate risk definition
- Arise from changes in interest rates incl.
o Impact on consumer behaviour
o Financial impact
FX risk definition
- Arises from exposure to movement in FX rates
What do changes in FX affect?
o Transaction exposure- foreign revenues and costs as expressed in home currency
o Economic exposure- prices of exported goods»_space; impact on foreign sales
o Translation exposure- consolidated accounts (think how FX affects results in segment reporting)
Basis risk definition
- Arises from differences in the movements of two comparable indices
Credit and counterparty risk
- Credit- risk counterparty to agreement is unable or unwilling to make payments required under agreement.
- Counterparty – Risk another party to transaction or agreements fails to perform contractual obligations, incl. performing them on time.
What else might credit risk refer to?
- May refer to risks relating to variations in credit spreads in the market
o Caused by changes in asset values e.g. for a corp bond, due to actual or perceived change in creditworthiness of issuer
o Sweeting considers it a market risk
o Changes in creditworthiness may be informed by assessment of risk of not meeting contractual obligations (in terms of quantity, quality or timing) in part/in full due do inability/decision of issue
Liquidity risk definition
- Funding- risk money markets can’t supply funding to organisations when needed
- Market - risk of insufficient market capacity to handle asset transactions at time when deal is required without sizeable change in price
Insurance risk definition
Risk from deviations in timing, frequency and severity of insured events, relative to expectations that were held when underwriting or pricing
Underwriting risk definition
risk of inappropriate selection and approval of insurance risk (component of insurance risk)
What are some components of insurance risk?
Mortality
Morbidity
Property
Persistency
Expenses
Casualty risks
Underwriting risk
Operational risk definition
Risk of losses due to inadequate / failed internal processes, people, systems or form external events.
Components of operational risk
- Processes
- People
- Systems
- Events
- Strategic risk
- Crime risk
Examples of risks in processes
Efficiency vs effectiveness
Errors
Inadequate documentation
Model and data risks
Examples of risks caused by people
Key positions unfilled
Wrong people employed / promoted / retained
Absenteeism
Lack risk awareness
Incompetence
Dishonesty
Agency risks
Moral hazard risks
Adverse selection
Examples of system risks
Out-of-date
Insufficient access or capacity
Unauthorised use / access to data
Technological failure
Inadequate back up systems / disaster plans
Software errors
Examples of risks brought about by events
Business continuity
Ineffective internal-change management
Ineffective external-change management
Example of strategic risks
Inappropriate business strategy
Inadequate business plans
Changes in external environment
Results not meeting s/h expectations
Reputational risk
Examples of crime risks
People risk
Technological / cyber risk
Legal risk
Environmental risk definition
- Relates to natural environment and human interactions with the environment
- Includes:
o Natural disasters and climate change
o Pollution
o Impact of declining natural resources
Legal risk definition
- Arises from understanding of and adherence to legislation, incl. changes in accepted interpretation
Causes of legal risk
o Breaching law e.g.
-Lack of awareness
-Lack of understanding
-Interpretation changes by law
-Deliberately
o Inability to demonstrate compliance with law
What are 3 things that legal risks relate to?
o New legislation due to political or social pressures:
o Clauses, terms, or conditions in contracts
o Court judgements against org
Political risk definition
- Includes:
o Risks related to political decisions and indecision
o Changes in govt
o Events related to political instability incl. terrorism and war
Conduct risk definition
- Risks relating to relationship between company and customers
Examples of things that might affect conduct risk
o Operational failures- poor quality control and/or servicing
o Information asymmetry
o Keeping up with regulation and customer needs
o Market conditions
o Product development activities
o Strategic objectives
Other risks
- Regulatory
- Agency
- Reputational
- Project
- Strategic
- Demographic (e.g. mortality rates)
- Moral hazard
- Social (e.g. population characteristics, e.g. age profile)
- Pension
- Residual risk
Examples of systematic risk
o Market return
o Industry-specific risks (limited number of sectors so can’t diversify fully)
o Interest rates for pension liabilities
Examples of non-systemic risk
o Non-systematic individual company return
o Components of insurance risk
Concentration of risk definition
Risk of relying on success of one action without back up plan if fails
Causes of concentration risk
o Inability to diversify and reduce risk
o Deliberate decision e.g. high expected returns in product/asset
o Poor risk management
Contagion risk definition
- Might be called “systemic risk”
- When financial losses in a company or sector or country leads to losses in another
- Exacerbated by media and way in which info is presented and spread
Examples of contagion risk
o Financial infrastructure- Failure of commonly used system e.g. visa
o Funding liquidity risk- e.g. 2008 credit crunch
o Common market positions- where change in one share price leads to further changes
o Exposure to common counterparty- failure in one leads to failure in one // loss of confidence in sector
o Credit contagion- default of one org leads to financial difficulties for creditors and suppliers»_space; more defaults etc
o Investors using the same flawed logic
